Thursday, April 30, 2015

Is this the end of the Bund bull market?

Fundamentally,
Bund yields have fallen too low and should move higher over the remainder of
this year. The move lower in recent weeks has been purely flow-driven to
speculate on higher prices amid a negative net supply given the ECB’s QE
purchases and due to the status of Bunds as a safe-haven in light of fears of
an imminent Greek default. As Greek default risks have receded somewhat and
consensus as well as positioning seems to have become heavily tilted on the
bullish side, it seems likely that the lows in 10y Bund yields are already
behind us.

First, The
Eurozone growth outlook has been improving and growth should rise markedly over
the course of this year, likely hitting approx. 2.5% on an annualised basis
before year-end. While structural challenges remain, cyclical forces are adding
up to a very strong growth tailwind. The weak Euro, low oil prices, reduced
negative growth effects from fiscal tightening, record low nominal and real
yields – at last also in the periphery – as well as a turnaround in credit
creation all act to lift growth. Moreover, amid the time lags involved, the
positive impetus will get ever stronger in the months and quarters ahead. Business
sentiment has improved noticeably since late last year and can improve
further.

Not only has real growth moved on an upward
path, but also the three years’ long disinflation has ended and headline
inflation rose already from –0.6% to 0% in April. The chart below shows the
Eurozone yoy inflation rate and divides it into three components. Commodity
price effects are marked in green (defined as the difference between headline
and core inflation), fiscal policy effects in red (derived from changes in
consumption taxes and prices for administered goods and services) and the
residual in blue. This residual can be thought of as the underlying price
pressures emanating from the private sector. As can be seen, disinflation was
mainly caused by falling commodity prices. Also a reduction in the price
effects of fiscal policy from 0.7% to only 0.1% in March was an important
driver. Underlying price pressures fell as well, from 1,0% at the end of 2011
to 0.1% in May 2014 with likely the strong Euro (reaching its high in March
last year) being responsible for approx. half of this drop. However, these
underlying price pressures have increased already and have risen to +0.5% yoy
last month. Core inflation of 0.6% in April – matching the record low of
January and March – masks the slowly increasing underlying price pressures amid
a reduction in the price effects of changes in consumption taxes. As a result, not
only headline inflation is likely to move noticeably higher in the months ahead
– as oil prices have started to recover – but also core inflation can rise
moderately into year-end.

This
combination of substantially rising real growth from below trend to markedly
above trend and inflation moving back into positive territory will exert
increasing upward pressure on bond yields as the year progresses. What is more
as these economic developments take hold doubts that the ECB will maintain its
ultra-easy monetary policy stance until at least autumn 2016 and speculations
that it will taper purchases and/or might increase the negative depo rate back
to 0% before that time should become increasingly stronger.

Moreover, the
rising uncertainty with respect to Greece and the threat of an imminent default
have also supported the safe haven of German government bonds in recent weeks.
The support provided by the latter has gone into reverse, however. The Greek
government introduced a bill which forces municipalities and state
enterprises to transfer their cash holdings to the central government providing
it with the necessary liquidity to fund upcoming loan redemptions. In
addition, over the past few days PM Tsipras has reshuffled the Greek
negotiation team, reduced the power of finance minister Varoufakis, suggested a
new list with reforms and hinted at a possible referendum for the public to
decide whether they accept the necessary reforms in order to secure a new
bail-out and stay in the Euro. All this has reduced the imminent default risk
and thus also the support for Bunds.

Furthermore,
ever since the ECB decided to engage in large scale asset purchases in
February, the main argument for buying Bunds was the negative net supply on the
back of large ECB purchases and a balanced budget. This lead to a
bull-flattening of the curve as investors piled into this shrinking asset
class. However, such a flow driven rally leads valuations ever further away
from fundamental developments (which as stated above suggest rising yields).
With the bullish sentiment becoming dominant and positioning likely tilted in
favour of longs, the additional buying by speculative accounts dries up whereas
the fundamentally driven accounts as well as life insurers and pension funds
have already moved to the sidelines amid too low yields and expensive valuations.
As a result, buying dries up – barring the ECB/Bundesbank - and it does not
take a lot to cause a wave of profit taking.

Finally, the technical market backdrop for Bunds
has deteriorated. As the chart below shows for 10y Bund yields, stochastics have
turned higher from oversold territory. In addition, the downward trend in place
since September last year (which was fuelled by QE speculation) has been broken
to the upside which provides a first bearish technical signal. This still
leaves another downward trend in place since the start of 2014 (which started
on the back of disinflation and weak growth). However, this more important
longer-term trend running at slightly below 0,40% needs to be broken first to
render the picture outright bearish. Still, over the past twelve months lower
Bund yields have dragged longer-dated UST and Gilt yields lower. Now, the
relationship has changed and higher UST and Gilt yields (which are already up
by approx. 40bp and 50bp respectively since their lows at the end of January)
start to put upward pressure on Eurozone yields.

Downward trend in 10y Bund yields in place since September has been broken to the upside

Source: Bloomberg

As a result,
I regard Bunds as fundamentally expensive and expect the fundamental
fair-value for yields to increase as the year progresses. The ECB’s purchases will
continue to keep Bund yields below any estimate of fair-value, however. Still
the upward pressure on yields should intensify during summer and I believe that
the yield lows are already behind us and the long Bund bull market has ended.
The process of a gradual duration reduction in Eurozone bond portfolios can
continue.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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